How Talent Pulls One Over on the Capitalists

Last week I got a call from the founding CEO of a startup in which I am an angel investor. Outside investors, including me, had provided its $10 million in risk capital about three years ago. The founding group of managers, including the CEO, took sweat equity in the business. He was calling to get my consent to sell the company for $31 million. That sounded pretty good – a threefold payoff on a three-year investment.

But after telling me the sale price, he went into a carefully structured description of how that $31 million was going to be split up. He began by telling me that things weren’t going as well as management had hoped and that they had determined the company needed to be sold to a major player in their industry. Only one buyer had come forward and if our company didn’t do this deal, it was at risk of running out of cash. The subtext was: take this deal or your investment is gone.

Then came the punch line: the buyer had insisted on a deal structure by which the outside equity providers would be paid $11 million – a annual return of 3% that looks suspiciously like the interest rate on a secure bond, not a risky startup investment. Meanwhile, the founding group would be compensated on the basis of an earn-out structured to pay them $20 million if they achieved some relatively reasonable targets. Talent had managed to extract an impressive 95% of the $21 million upside, leaving the risk capital providers with only 5% — a nearly perfect extraction of value.

Perhaps I shouldn’t have been surprised. Last year, I wrote an article for this publication showing how over the past two decades, talent has taken over as the dominant factor in the economic equation, and today is using its bargaining power to extract an ever-greater share of the value it helps create. Hedge fund managers exemplify the phenomenon: with their clever combination of annual fees and carried interest charges, they take as much as 84% of the fund’s net earnings, while the actual providers of the risk investment capital get the remaining tiny sliver.

But of course, it’s not just hedge fund managers. As my personal experience attests, value extraction by talent can be a problem in new ventures as well.

Normally, equity investors in a new venture provide risk capital, reaping all of the upside in exchange for accepting the risk of losing 100% of their capital before debt holders take a hit. Debt providers accept a limited and fixed upside in exchange for downside protection by the equity capital. Meanwhile talent is given a free share in the equity as motivation. But in the modern talent-centric economy, we’re increasingly finding that talent manages somehow to secure itself a privileged position relative to the equity investors who purchased their stakes – to the extent that the latter are effectively being converted into debt holders.

As our phone call wound down, the CEO I’d backed explained that he had tried as hard as he could to get the seller to provide a more reasonable split of the upside but apparently his pleadings were of no avail. That’s not very surprising, of course, because the outcome was fully in the interests of both parties. The buyer got to make sure that the founders were fully motivated to achieve the earn-out targets and could not have cared less about the equity providers. And the founders got to keep 95% of the upside, rather than the minority proportion that their actual share ownership would have dictated.

It’s hard to see what we shareholders could have done about this. If we had refused, the founders could simply have walked away from the deal and we would have ended up with nothing. You could say that it’s just the risks of playing the game. Maybe. But I do worry that this kind of behavior will ultimately have a negative impact on economic growth. Who will ever want to provide risk capital if all they can rely on is a sense of guilt or obligation on the part of the entrepreneurial talent they’re expected to back?